U.S. financial regulators are not (yet) comfortable with a publicly-traded bitcoin ETF as witnessed by the SEC’s rejection of the Winklevoss Coin ETF. However, it turns out that they are comfortable with granting institutional investors access to bitcoin derivatives.

On July 6, the U.S. Commodity Futures Trading Commission (CFTC) announced that it had given LedgerX, an institutional digital currency derivatives trading and clearing platform the permission to create a Swap Execution Facility (SEF). It has, thereby, approved bitcoin options trading for hedge funds, CTAs, and other institutional investors.

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Swap Execution Facilities (SEFs) are trading platforms that operate under the regulatory oversight of the CFTC for the trading of swaps. The Dodd-Frank Wall Street Reform and the Consumer Protection Act of 2010 authorized the creation of SEFs in an effort to better oversee and regulate swap trading activities in the U.S.

According to the CFTC’s press release, “the CFTC issued the Order under Section 5h of the Commodity Exchange Act (CEA) and CFTC Regulation 37.3(b). After review of the LedgerX application and associated exhibits, the CFTC has determined that LedgerX demonstrated compliance with the CEA and the CFTC’s regulations applicable to SEFs. The terms and conditions of the Order require, among other things, that LedgerX complies with all provisions of the CEA and all requirements in the CFTC’s regulations, as may be amended or adopted from time to time, that are applicable to SEFs.”

With the SEF status granted, LedgerX is on its way to becoming the first fully-regulated bitcoin options exchange and clearinghouse that lists and clears fully-collateralized, physically-settled bitcoin options for the institutional market.

New York-based LedgerX LLC was founded in 2013 by Paul Chou, Zach Dexter, Juthica Chou, and Paul Chau with the aim to build a digital currency derivatives trading platform for institutional investors. The company received $1.5 million of seed funding in February 2014 led by Blockchain Capital and managed to secure further funding during its Series A in July 2014 led by Lightspeed Venture Partners. In 2017, LedgerX managed to secure $11.4 million of funding during its Series B from Miami International Holdings and Huiyin Blockchain Venture to develop its platform further.

Bitcoin Options But No Bitcoin ETF

While it may come as a surprise that bitcoin options become publicly tradable before a bitcoin ETF given that options are inherently more risky, the most likely reason for that is that LedgerX CEO, Paul Chou, also serves as the bitcoin expert on the technical advisory committee of the CFTC. The technical advisory committee advises the CFTC on the effects of innovative new technologies on the securities market and suggests legislative and regulatory responses to technological changes in the financial markets. By given close access to the decision makers at the CFTC, Chou had the chance to successfully lobby for his platform to become a registered Swap Execution Facility (SEF) and to make fully-regulated exchange-traded bitcoin options trading a reality in the U.S.

LedgerX is now one of 25 CFTC registered SEFs. However, LedgerX still needs to go through the process to become a registered Derivatives Clearing Organization (DCO) to fulfil its mission to cover the full bitcoin options trading lifecycle.

According to the CFTC: “Any clearinghouse that seeks to provide clearing services with respect to futures contracts, options on futures contracts, or swaps must register with the CFTC as a DCO before it can begin providing such services [and] must comply with the DCO core principles established in Section 5b, 7 USC § 7a-1, of the Commodity Exchange Act (CEA).”

How Bitcoin Options Trading Works

Options are financial derivatives that give investors the right but not the obligation to buy (or sell) an underlying asset (in this case bitcoin) at a specific price on or before a predetermined date. These financial instruments allows investors to bet on the price development of bitcoin using leverage, but it also allows investors to hedge their bitcoin exposure against extreme price drops.

For example, an investor who is long bitcoin at $2,500 can also purchase a put option on bitcoin with a strike price of say $2,000 and an expiry date of three months from now. So, if bitcoin drops below $2,000 within the next three months, the bitcoin put option would then be “in the money” and can be exercised. In that case, the investor makes a loss on his original bitcoin long position but recovers some or all of that loss using the profits from his bitcoin put option. How much or how little of the loss can be covered would depend on the hedge ratio of his or her put option.

In other words, how many put options he or she bought to cover potential losses. Should the price of bitcoin not drop below $2,000, the bitcoin put option would then expire worthless after three months, and the holder would only lose the small fee he or she paid for the option. At this point, the investor could purchase a new bitcoin put option to hedge his long position again or decide to accept the full market risk of holding bitcoin.

It may be surprising to some to see bitcoin options enter the market before a publicly-traded bitcoin ETF. However, it is definitely another big step forward for bitcoin to become a fully-recognized asset class for institutional investors. Now that investors will soon be able to hedge their bitcoin risk using exchange-traded and regulated bitcoin put options, it would not be surprising to see more hedge funds add bitcoin to their portfolios as they now have better means to manage their bitcoin risk.

In addition, speculative buying of bitcoin call options that bet on a price increase will likely also increase, which will lead to more institutional-driven price action for the price of bitcoin in the coming years.

The more accepted bitcoin becomes as an asset class, the more legitimacy will be given to the digital currency. This, in turn, will not only push up the value of bitcoin but it will also help the entire bitcoin ecosystem to grow.